Independent contractors, consultants and freelancers are one of the fastest growing business types in the U.S. Freelancers alone represent 34 percent of the U.S. workforce and provide other businesses with services and expertise that can’t be found in-house, oftentimes becoming an integral part of a company’s workforce. This perception, however, can sometimes become problematic.
On the surface, independent contractors often fulfill the same duties as a regular employee, but sometimes the lines between independent contractors and employees get blurred. And that can get you into hot water with the IRS. Here’s why:
Why you need to consider the IRS when hiring contractors
One of the benefits of hiring independent contractors is that you aren’t required to pay them a salary, benefits or withhold employment taxes in the way you would for employees. The IRS has upped its efforts to collect employment taxes and is clamping down on employers who misclassify employees as independent contractors (deliberately or otherwise).
Statistics suggest that up to 30 percent of firms are misclassifying contractors so understanding the difference between an employee and an independent contractor is hiring 101. The consequences of getting it wrong can be painful – no one wants to deal with IRS penalties, back payments and interest on uncollected payroll taxes.
The difference between an employee and an independent contractor
The IRS imposes a broad definition of what constitutes an independent contractor versus an employee: “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
For example, if you exert any type of control over when, where and how the actual work is performed by an independent contractor, you may be getting into murky waters.
The independent contractor test
Don’t assume that just because you hire the worker as a contractor that the relationship has remained that way. If you work with independent contractors and are concerned that you may be misclassifying them, consider the following:
An independent contractor:
- Operates under a business name
- Has his/her own employees
- Maintains a separate business checking account
- Advertises his/her business' services
- Has a contract with you describing the relationship
- Invoices for work completed
- Has more than one client
- Has own tools and sets own hours
- Keeps business records
Whereas, an employee:
- Performs duties dictated or controlled by others
- Is given training for work to be done
The IRS offers more guidance on the dynamics and differences here.
If you’re still not clear on the issue, the safest bet is to classify the worker as an employee – but do seek the advice of your accountant or attorney before doing so. In addition, the IRS can help make the determination for you via Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
There is a safe harbor!
If you believe you may have misclassified workers, you do have the opportunity to reclassify your workers as employees for future tax periods through the Voluntary Classification Settlement Program.
Again, talk to your tax advisor or attorney about the pros and cons of the program in the context of your business situation and risk.
Learn more in this IRS guide: Independent Contractor (Self-Employed) or Employee?